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Libor Spike Is Rekindling Fears Of Another Financial Crisis

Tuesday, 25 May 2010 | 2:15 PM ET

A recent spike in the rate banks charge each other for short-term borrowing is reviving investor fears that the market is returning to the abyss of the credit crisis.

By historical standards, the London Interbank Offered Rate, or Libor , remains at extremely low levels, with the closely watched three-month rate moving to 0.5363 percent Tuesday. It was the 11th straight day the rate rose.

But a rise to levels not seen since July 2009—coming as a debt crisis cascades through Europe and reverberates around the globe—has spurred concerns that banks will tighten up lending just as the global economy was showing signs of a sustainable recovery.

"You have to look at the direction much more than you have to look at the actual nominal level," says Michael Pento, chief market strategist at Delta Global Advisors in Parsippany, NJ. "The direction is telling you where the economy is heading. It's very bad."

Spiking Libor rates have underscored the fear that debt problems in Greece, Spain and elsewhere will spread because of the exposure from European Union banks. That could cause subsequent contagion across the Atlantic, where US banks have significant exposure to EU institutions.

The fear is that already-weak bank lending trends will only be aggravated as Libor churns higher and thus stall the US economic recovery.

"We didn't learn much from the 2008-2009 credit crisis," Pento says. "One of the things we forgot is there's no such thing as decoupling. When investors were absolutely positive that China and Australia and the rest of the emerging markets would be unscathed by our credit crisis, they were proven completely wrong.

"Today they are telling us the United States is immune from the sovereign credit crisis in Europe. They are completely wrong."

To be sure, if the most recent incidents are indicative of anything it's that things can change rapidly in such a volatile global economy. After all, it was only a few weeks ago that economists were touting a sustainable global recovery and strategists were encouraging clients to pile into emerging markets.

And the Federal Reserve's fed funds rate, which is the US counterpart to Libor, has not budged, though it is under more centralized control than the European rate.

The spike in Libor, then, could be a problem until it isn't anymore, and that can happen quickly.

"People understand the policy response a little better than they did in 2008," says Nicholas Colas, chief market strategist at ConvergEx, an institutional investment advisory firm in New York. "In 2008 you had a real power vacuum in the White House because you had a president-elect and a lame-duck economic team. Now at least you have some continuity in decision-making and people understand how central banks respond to credit markets."

But inasmuch as the European crisis is reflected in Libor rates, there appears to be at least some cause for worry.

At the most universal level, mortgages are closely tied to Libor rates, and some $350 trillion in global derivatives and corporate bonds also are linked. The housing market has been unable to recover even with extremely low rates. A run higher, even as low Treasury yields have kept mortgage rates down, might prove another stumbling block for the sector to grow.

The Fed also will be limited in what it can do to mitigate effects from a Libor surge.

Most recently the Fed agreed to currency swaps with European banks who want US dollars in place of the shrinking euro. Analysts say that will help put liquidity into the system and aid somewhat in keeping other lending rates low, but will not be able to stem a fast jump in Libor.

"They think the Fed kind of runs the show and they do to a large degree. But there's a limit to it," says John Lekas, CEO of Leader Capital Group. "There's only so long you can put your foot on the free market and hold it down. Eventually it bubbles up. It's like putting your foot on a volcano."

Lekas, who is portfolio manager of the Leader Short Term Bond Fund, believes the Libor increase is signaling a double-dip for the economy that will send the Dow industrials to as low as 5,000 by the second quarter of 2011 and the 10-year Treasury note yield to 2.75 percent by the end of 2010. The Leader fund is ranked three stars by Morningstar.

"It really is the worst of both worlds," he says. "Your cost of capital is going to get significantly higher, and what you charge for services is going to get significantly lower."

Yet Lekas believes both US and Europe will emerge stronger by 2012 as the cost of doing business gets lower and companies reap the profits.

Delta Global's Pento also believes the economy is heading lower but does not see stocks getting battered as badly, mostly because the Fed can still print money to boost nominal dollar values of stock prices.

Mike O'Rourke, chief strategist at BTIG in New York, says the Fed's currency swaps will help quell the crisis somewhat. And both he and CovergEx's Colas say only another major policy or geopolitical blowup would cause a major economic crisis.

"The only reason people should fear a double-dip is if some type of event would occur, like a big bank would fail that we had exposure to," O'Rourke says. "It's a fear about financial risk and a fear about contagion. (The Libor increase) shouldn't have any real economic consequences unless it leads to some other event."

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